Insider Scandals Reveal Cracks in 'Chinese Wall'

When Staley Continental last week sued the investment firm of Drexel Burnham Lambert, charging that its traders tried to bully the Illinois food company into hiring Drexel as an investment banker, it meant more than some extra controversy for Drexel, already notorious for financing bitter corporate takeovers.

The charges, vigorously denied by Drexel, brought fresh attention to an old, yet unresolved, controversy: whether Wall Street is riddled with conflicts of interest, and whether the safeguards against potential abuses are adequate.

Wall Street firms have long maintained that there is a "Chinese Wall"--a term the industry coined years ago--that separates their various departments. For example, traders in many instances are supposed to operate independently of investment bankers who make merger deals or arrange financing for corporate clients.

Investment bankers are obligated to protect a client's non-public information, yet brokers or traders seek to make money through well-informed investment decisions. Traders obviously can make easy money if they know in advance of deals being cooked up by their investment banking colleagues. And investment bankers aren't supposed to line up clients by threatening to have their colleagues in the trading department throw the market for a company's stock into disarray, as Staley Continental alleges Drexel did.

Trading and investment banking are supposed to coexist on opposite sides of the Chinese Wall, until a deal becomes imminent and trading legally must be halted in the investment banking client's securities.

Now critics question the strength of those self-erected walls amid the arrest or conviction of nearly a dozen top Wall Street executives on insider trading charges. "They have a wall, but it's made of Swiss cheese," says Kenneth McLean, staff director of the Senate Banking Committee, which is investigating potential abuses and weighing legislative reform.

Charges earlier this month against Robert M. Freeman, a top trader at Goldman, Sachs & Co., illustrate what critics say is a breach of the Chinese Wall. The government alleges that Freeman obtained confidential information about one or more of Goldman's investment banking clients. As a trader, he should not have been privvy to details of the deals.

Freeman was accused of passing the inside information to Martin A. Siegel, the former top mergers specialist at Kidder, Peabody & Co. Siegel, for his part, has already pleaded guilty to accepting a tip from Freeman and passing it to Kidder Peabody's department specializing in arbitrage--an activity that involves speculating in the stocks of firms involved in takeover attempts. Presumably, Siegel also breached a Chinese Wall to communicate with his firm's arbitrageurs.

Investment houses have had policies to curb the flow of confidential information ever since the Securities and Exchange Commission narrowly recommended to Congress more than 50 years ago that Wall Street firms be allowed to trade securities and make finance deals under one roof.

The SEC does not dictate what the policies should be. However, in the 1968 settlement of a case against Merrill Lynch, Pierce, Fenner & Smith, the agency made clear that it expects to see a Chinese Wall between various departments. And in 1980, federal securities laws were strengthened to penalize those who communicate insider tips about tender offers.

Despite these efforts, recent maneuvers by some corporate raiders, arbitrageurs and investment bankers have prompted fresh concern in at least three areas. How diligently does a firm instruct its employees about its Chinese Wall policies? Can arbitrageurs be successfully walled off from other units of a Wall Street firm? And finally, should investment bankers or traders accept seats on a client's board of directors?

"Merrill Lynch's compliance procedures are believed to be among the finest in the industry and, since we are not involved in the current controversy, we wish to say no more," said William Clark, vice president of media relations.

Executives at several other firms spoke only on the condition that they not be identified. Some said their firms did not want to invite congressional subpoenas to testify about their practices; others said they wanted to avoid boasting publicly about their precautions, lest one of their own executives be exposed in coming weeks.

Privately, new recruits in two firms' mergers and acquisitions units said last week that despite the hoopla over insider trading, they've never been instructed by their superiors whether they should talk to arbitrageurs. The newcomers added, however, that they've never been contacted by such a trader.